Tuesday August 16

Stocks retreated today following a few days of gains as a result of comments made by some Fed officials. The S&P 500 lost 0.6% to 2,178 and the Dow Jones fell 0.5% to 18,552. Telecom companies fell by the most compared to other sectors. Financials and transportation shares were mostly unchanged and utilities sold off 1.2% as they are negatively affected by higher interest rates. Treasuries sold off today, with the 10 year rising 2bp to 1.58% and the 2 year rising 2bp to 0.75%. 2s 10s was flat around 83bp. Economic data today showed that headline CPI was unchanged on a monthly basis, while core CPI rose just 0.1% on the month. On an annualized basis it was up 0.8%, with the core number at 2.2%. However industrial production beat estimates coming in with a strong reading of 0.7% and 0.5% for manufacturing which both beat estimates by a healthy margin. The US dollar fell following that data which runs contrary to the movements in Treasury markets. USD lost 1% against JPY to Y100.22 after falling as low as Y99.53. The euro rose 0.8% against USD to $1.1276. The 10 year bund yield rose to -0.03%. Brent rose 1.8% to $49.23 and WTI rose 1.9% to $46.60.

Rates sold off today as a result of comments made by FOMC members. Bill Dudley of the New York Fed today said that a rate hike in the second half of the year is possible, and did not rule out September if the economy improves enough. Later in the day Dennis Lockhart of the Atlanta Fed echoed a similar tone saying that economic data justifies the conversation for higher rates. These could be other examples of Fed officials trying to come across as hawkish while investors continue to underestimate the validity of their comments. This time the market for Fed funds futures responded to the comments, and the market now reflects a 54% chance of higher rates in December.

John Williams of the San Francisco Fed said that the FOMC should consider lifting their inflation target given the current environment. John Williams argues that higher inflation target would give the Fed more room to manoeuvre. Essentially by waiting longer for inflation to reach a certain level and letting the economy “run hot” he is suggesting leaving a wider margin for error compared to a 2% inflation target. This comes as an increasing number of officials both inside and outside of the Fed are beginning to believe that the natural rate of interest may be lower than it was prior. Eric Rosengren of the Boston Fed has made similar comments in the past, as well as top officials from the IMF and the US Treasury.

Economic data today showed that inflationary pressures in the US remain muted. Core inflation on an annual basis fell to 2.2% compared to 2.3% at the last reading. At the same time Bill Dudley made comments suggesting investors were underpricing the possibility that the Fed raises rates. Dudley said that following a slow 1H, the economy in the second half of the year was likely to show more signs of growth. Overall inflation rose just 0.8% y/y and investors will need to see a significant change in this number before shifting their views on the Fed. With rates selling off today, that shows that investors are responding more to the comments made by Dudley as opposed to the economic data and the report put out by Williams, which was interpreted initially as dovish by investors.

With interest rates going negative across the world banks have looked for alternative places to park cash. Banks are having to weigh whether or not it is cost effective to park cash in heavily guarded vaults as opposed to holding it at the ECB. Banks are paying 0.4% to hold their funds at the ECB, and that policy is intended to spur lending and growth. Munich Re and Commerzbank have both taken steps to convert negative yielding bank deposits to cash. If these banks succeed in taking their money out of negative yielding deposits, that could negate the intended effects of monetary policy. The costs include storage and transportation. Problems include bank robbers, earthquakes, and other disasters that could create chaos where the cash ends up being stored. One obstacle is that banks need approval from national central banks to withdraw deposits into cash.

Counterintuitively junk bonds have rallied post Brexit, and within high yield lesser credits have outperformed even further. The yield on the BAML US high yield index is as low as it was last June before oil prices touched bottom, before China’s devaluation, and before Brexit. The global search for yield has driven investors into riskier assets, which is a bullish technical for high yield. Nearly 50% of the European high yield market yields less than 2% due to negative government yields across that region. 18% of the world’s yield comes from US junk bonds in spite of the fact that those bonds make up only 4% of the total bond market. In February the spread on the BAML index was +850, which now stands at +534. Defaults in the US remain low at 5.5%, and are even lower in Europe at 2.6%.

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Tuesday August 16

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